Tuesday, July 24, 2012

A Missing Ingredient

Ryan Avent makes a good point about San Francisco Federal Reserve President John Williams' recent FT interview.

Avent is less impressed than me on Williams' conversion to open-ended QE as a policy tool because it by itself does not communicate a willingness to allow inflation to exceed 2%. I think that Avent is on the right path. While Williams did make what I think is a big step, he could go one step further and not only call for open-ended QE, but to do so in the context of Chicago President Charles Evans' suggestion for explicitly tolerating inflation up to 3%. That said, I also think this is too much to hope for, as I haven't seen any indication that Williams would be willing to deviate from the 2% target.

Also, you can interpret open-ended QE as a higher possibility that the Federal Reserve will not be able to pull-back the increase in the money supply, thus one could expect higher inflation in the future. And by leaving the program as open-ended, you remove the uncertainty created by arbitrary end dates and purchase amounts. So I do think that Williams is making a significant shift in the right direction. But I agree with Avent that a clear communication of tolerance for higher inflation would be even more effective.

Ultimately, I think the Federal Reserve made a huge policy error in committing to an explicit 2% inflation target. I think policymakers were under the impression that such a commitment would give them more flexibility by removing concerns that QE would be inflationary. In reality, I think it had the opposite effect - it eliminated a policy tool, thereby reducing their flexibility. And that commitment stands as a barrier to Evans' suggested policy path. I think the rest of the Fed would loathe accepting inflation as high as 3% given they just committed to 2% at the beginning of this year. In doubt, they would view such backtracking as a threat to their much-cherished credibility.

Interestingly, they don't see Treasury rates below 1.4% as a threat to their credibility. They really should.

Comments

A Missing Ingredient

Ryan Avent makes a good point about San Francisco Federal Reserve President John Williams' recent FT interview.

Avent is less impressed than me on Williams' conversion to open-ended QE as a policy tool because it by itself does not communicate a willingness to allow inflation to exceed 2%. I think that Avent is on the right path. While Williams did make what I think is a big step, he could go one step further and not only call for open-ended QE, but to do so in the context of Chicago President Charles Evans' suggestion for explicitly tolerating inflation up to 3%. That said, I also think this is too much to hope for, as I haven't seen any indication that Williams would be willing to deviate from the 2% target.

Also, you can interpret open-ended QE as a higher possibility that the Federal Reserve will not be able to pull-back the increase in the money supply, thus one could expect higher inflation in the future. And by leaving the program as open-ended, you remove the uncertainty created by arbitrary end dates and purchase amounts. So I do think that Williams is making a significant shift in the right direction. But I agree with Avent that a clear communication of tolerance for higher inflation would be even more effective.

Ultimately, I think the Federal Reserve made a huge policy error in committing to an explicit 2% inflation target. I think policymakers were under the impression that such a commitment would give them more flexibility by removing concerns that QE would be inflationary. In reality, I think it had the opposite effect - it eliminated a policy tool, thereby reducing their flexibility. And that commitment stands as a barrier to Evans' suggested policy path. I think the rest of the Fed would loathe accepting inflation as high as 3% given they just committed to 2% at the beginning of this year. In doubt, they would view such backtracking as a threat to their much-cherished credibility.

Interestingly, they don't see Treasury rates below 1.4% as a threat to their credibility. They really should.